Surge in inflation threatens loan rates

Homeowners were last night faced with the threat of the first rise in mortgage costs for two years after dearer food and fuel led to the largest one month increase in inflation since the 1990 Gulf war crisis.

News that inflation surged from 1.9% to 2.6% in January and broke through the government's 2.5% target shortened the odds in the City on a base rate rise next month.

Sir Eddie George, governor of the Bank of England, sought to calm nerves last night, describing the rise in inflation as "to some extent erratic", but warned that interest rates might have to go up if consumer demand did not ease in the coming months.

"I don't suggest the timing of any such move is imminent," he said, "that would obviously depend on the timing and the strength of the recovery abroad."

But, with the global economy showing signs of recovery and last year's seven cuts in interest rates fuelling a consumer borrowing binge, dealers in the money markets said there was a 75% chance borrowing costs would go up in March.

The sharp decline in inflation last autumn had raised hopes that interest rates might be reduced further from their current level of 4%, but analysts said this was now off the agenda.

The increase in the underlying inflation rate - which excludes mortgage interest payments - was accompanied by a sharp rise in the all-items inflation rate from a 42-year low of 0.7% to 1.3%.

Across-the-board increases in prices were responsible for last month's big jump in inflation, the office for national statistics (ONS) said. Bad weather in Spain pushed up the price of lettuces, tomatoes and cucumbers, retailers cut prices less than usual in the January sales, and motorists saw petrol prices rise at the pumps.

Household goods and services were also more expensive than a year ago, the ONS said, with higher phone bills and higher charges for utilities such as gas and telephone.

The ONS's breakdown of yesterday's data showed that inflationary pressure is strongest in the service sector, which is more sheltered from intense global competition than manufacturing. While the tumbling prices for computers has meant inflation in goods has been limited to 0.5% over the past year, service-sector inflation stood at 4.6% in January, up from 4.1% in December.

Analysts said there were signs that retailers were also taking advantage of strong consumer demand to force up prices, after years in which profit margins have been squeezed. "The clear implication is that retailers widened margins aggressively in January," said Jonathon Loynes of economics consultancy Capital Economics.

Despite last month's increase, the UK still has an inflation rate below average for the European Union, and industry leaders last night urged the Bank to resist the temptation to raise rates.

The chief economist of the Engineering Employers' Federation, Dougie Peedle, said price rises were still "off the radar screen" for recession-hit manufacturing. "Any calls for rates to rise on the basis of these figures would, we believe, be an over-reaction," he said, calling on members of the Bank's monetary policy committee (MPC) to "keep their heads cool over the coming months".

Sir Eddie said the Bank, which publishes its quarterly inflation report today, understood the concerns of manufacturing.

"If, as we move forward, it seems likely that the overall economy will be weaker than we currently expect, and inflation lower, then we are prepared to reduce interest rates further, just as we are ready to raise them if the overall economy, and inflation, appear likely to be stronger than we currently anticipate."